Three weeks ago, George Soros observed that there are “eerie resemblances” between the global financial crisis of 2008 and China’s credit markets. In a blog post on the 20th, I warned of the dangers of China’s local debt crisis, particularly the “shadow banking” element. Today, a Chinese trust investment worth USD 496 million (RMB 3 billion) went bad and will likely default by the 31st. The company, China Credit Trust & Co., made opaque loans to the Shanxi Zhenfu Energy Group, a coal miner, which collapsed in 2012 after a leading shareholder was arraigned for illegal deposit-taking. If it defaults, the company will be the first of some 10000 shady non-bank creditors to do so. The ICBC (Industrial and Commercial Bank of China, the largest bank in the world) has preemptively declined bailing out holders of the financing, despite allegedly guaranteeing the project to investors.
Also today, a hacker broke into CNN’s Twitter and Facebook accounts, taking the opportunity to declare that China had put all its US treasury bonds on the open market and proclaimed the South China Sea a “closed-zone.” The announcements were quickly deleted, and despite markets apparently not taking them seriously, they brought to mind Former Prime Minister of Japan Ryutaro Hashimoto’s statement at Columbia University in June 1997 that “several times in the past, we have been tempted to sell large lots of US Treasuries.” Within seconds, the dollar plunged and yields surged. Contrarily to the US, more than 90% of Japan’s debt is held domestically, reducing the risk of this kind of capital flight.
China has steadily built up a currency stockpile worth USD 3.8 trillion (RMB 23 trillion) since Asia’s 1997 crisis, but according to William Pesek over at Bloomberg View, China would be better served investing at least some–and probably most–of this wealth in clean energy, public services, infrastructure, and education. Therein lies the paradox: to unload any significant portion of these treasury bonds, China would have to absorb massive capital losses. US interest rates would soar. And China’s biggest export market would disappear.
Perhaps if China fails to reign in local debt and divert capital away from construction, resulting in a real crisis, this mountain of bonds will come in handy. Excluding this increasingly plausible scenario, they are only a weakness (or according to Pesek, a pyramid scheme).
You really have two unrelated topics here. One is problems in China’s shadow banking system. So ask yourself, under what conditions do shadow banks have a leg up over other financial institutions? One component of course should be familiar from the US: no regulation. The scandal / fraud component indicates that’s part of the story in China as well. China may not have a democratic political system, but to the extent that it is authoritarian, is is powerful only in very narrow areas: however strong-arm our image of the government, it is unable to effectively regulate private businesses or even sub-national political units. However, that’s more an enabler of “shadows.” So what else is going on?
The other is China’s foreign assets [with a digression into Japan issues]. As we will see later in the term, you can’t simply turn – rather, convert simply – foreign assets into domestic ones: for every Chinese seller of bonds there has to be a domestic purchaser of bonds, or on net the government just ends up swapping T-bills for dollar bills. [Their capital loss story is likely exaggerated, but that’s another issue.] Pesek ought to know that – he had a book that came out in late fall, I have a copy and am looking at it to see whether it might be good to use as a text the next time I teach the course (in Fall?).
I realize the topics are, on the face of it, unrelated–however my intent was to illustrate the case for and against building large currency reserves. If a debt-crisis similar to Japan’s occurs, the treasury bonds will become useful, but otherwise they are a diversion away from domestic investments. And at USD 3.8 trillion, it is one expensive insurance policy.
Arguably, China actually spurred the local debt crisis by promoting infrastructure and housing development spending to increase growth–which, given the limits on borrowing from banks, encouraged the “shadow banking” element. The rhetoric from the central government has now changed, and hopefully we will see concrete steps to structurally change local borrowing and spending habits.
I, as well as Pesek, understand that China cannot now convert their hoard of Treasury bonds into domestic assets (it is the “paradox” I referred to)–I think you misunderstood me. Pesek argues in the article I linked to that at least some of these bonds should never have been purchased in the first place. I was unable to find the book by Pesek you mentioned, but did see that he has a book coming out in May titled Japanization: What the World Can Learn from Japan’s Lost Decades, which sounds like it could be relevant to the local debt issues I have been blogging about.
What debt crisis in Japan?
Again, we need an “open economy” model to understand where China’s foreign assets came from – an excess of domestic production relative to consumption, otherwise known as a trade surplus. But of what value is that?? And how to avoid?? Thus the discussion of “rebalancing.”
I was referring to Japan’s 1990 debt crisis which followed the asset price bubble in 1989 and preceded the so-called “Lost Decade.”
Recent reports suggest that “shadow lending” is now decreasing, as is new development of rural land. This is promising. I think the problem is not China’s trade surplus, but rather the perverse incentives that led to rapid overdevelopment of rural lands and unsustainable deficit spending by municipalities.